Numbers Game

Imagine you are a manufacturer of widgets. You have a sizable factory and a loyal customer base. Your business is growing steadily and you’re making money.

One day your best customer says, “I love your product, and you’ve treated us well, and your price has been reasonable. But I’m leaving you, because I see from your annual report that you’re doing very well. Your profits are healthy – too healthy. So I’m going to start buying my widgets from a company that’s barely breaking even. And I’ll do that even if that company’s product isn’t as good as yours, and even if it costs me more. I mean, I’ve been buying from you for several years now. Time to move on! Sorry!”

As bizarre as that seems, something like that happens all the time with nonprofits and their funders.

Nonprofits don’t produce widgets; rather, they provide services. And though the customers often pay for the services (buying tickets at theaters, or paying tuition at schools, or purchasing admissions at museums), often the money to support the operations is provided by a third party. It might be a government agency, or a foundation, or the United Way, or private donors.

These third parties like the nonprofit to be in the black. They don’t want to support a failing enterprise. Very few funders respond well to an organization pleading for a bail-out. “Give us money so we can stay in business” is not a compelling pitch.

And funders can be punitive if the nonprofit records even a single year where the operating budget is in the red. The pull back their support, they increase their scrutiny, and, in many cases, they lead a stampede away from the organization that turns a one-time deficit into a perpetual shortfall.

That said, for a variety of reasons, not all of them rational, funders don’t want nonprofits to do much more than break even. If the nonprofit’s surplus is greater than about 5% in a given year, a lot of funders will consider that you’re not worthy of continued support, even if the big surplus was because of unusual one-time-only circumstances. They think you have more money than you need. In a very real way, these funders penalize nonprofits for careful management. And, of course, by pulling away their funding, they may trigger a deficit in the next fiscal year.

I’ve written before about how reducing nonprofit performance to simple measures has unintended negative consequences. For example, when funders put too great a focus on how much organizations spend on their fundraising, it causes nonprofits to game the system and misrepresent their actual costs – or to spend too little on legitimate fundraising strategies.

Balancing the operating budget is undoubtedly important. But funders’ obsession with this one measure, and their strong preference that the budget is balanced by just a little bit, also encourages a certain gamesmanship on the part of the nonprofit. Some examples:

  • If the nonprofit knows it will easily balance its budget, it may rush to spend money before the end of the fiscal year — usually in fairly innocuous ways, like pre-buying some supplies for the next year.
  • More importantly, an organization may steer away from a much-needed program expansion for fear of having the budget out of balance for one year or another — not a structural deficit or anything that would risk its fiscal integrity, but enough of a bump to raise eyebrows among funders.
  • A nonprofit might even worry about accepting a major undesignated gift that would make the organization suddenly appear to be too rich.

I can’t imagine people saying, “I won’t buy an iPhone because Apple made too much money last year.” I also don’t think many people say, “I won’t buy a Camry because Toyota spends too much on marketing.” Those are laughable scenarios. But people look at nonprofits differently. They get judgmental. Moralistic, even. They worry too much about “how it looks.” And that causes nonprofits (also worrying about how it looks) to act irrationally and to make decisions that are not necessarily in the best interests of their mission.

Evaluating the effectiveness of a nonprofit is difficult. Trying to figure out where a donated dollar has the greatest impact is harder still. Funders need to look at a lot of factors. Balancing the operating budget, and by how much, is only one of many things to examine: it’s important, but not decisively so.  Overemphasize it at your peril.

[Note: If you want to read a terrific set of articles on the foibles of nonprofit accounting and financing, check out essays by Clara Miller, formerly the president of the Nonprofit Finance Fund, now the president of the F.B. Heron Foundation.]

Copyright Alan Cantor 2012. All rights reserved.

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2 Comments. Leave new

Al,
You’ve raised an important topic. When I was ED of a small health foundation, we decided that our funding should go to the organizations that were doing the best job addressing the community’s health care needs, regardless of whether we had funded them in previous years. From time-to-time, some board members would get antsy about supporting an organization over multiple years, sometimes for the reasons you mention in your blog.
But when we talked it though–our goal is to improve the health of the community, this grantee has one of the best strategies to accomplish that and has consistently demonstrated positive outcomes–they generally came around to seeing that continuing to fund such organizations was a key part of how we met our mission.
Tom

Reply

    Thanks, Tom.

    You give a good description of a smart approach — and what’s striking is how such a logical, high-return strategy even required “talking through”! But good for you for persevering and doing the right thing!

    Reply

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